Credit Spreads and Business Cycle Fluctuations
AbstractThis paper examines the evidence on the relationship between credit spreads and economic activity. Using an extensive data set of prices of outstanding corporate bonds trading in the secondary market, we construct a credit spread index that is—compared with the standard default-risk indicators—a considerably more powerful predictor of economic activity. Using an empirical framework, we decompose our index into a predictable component that captures the available firm-specific information on expected defaults and a residual component—the excess bond premium. Our results indicate that the predictive content of credit spreads is due primarily to movements in the excess bond premium. Innovations in the excess bond premium that are orthogonal to the current state of the economy are shown to lead to significant declines in economic activity and equity prices. We also show that during the 2007–09 financial crisis, a deterioration in the creditworthiness of broker-dealers—key financial intermediaries in the corporate cash market—led to an increase in the excess bond premium. These find- ings support the notion that a rise in the excess bond premium represents a reduction in the effective risk-bearing capacity of the financial sector and, as a result, a contraction in the supply of credit with significant adverse consequences for the macroeconomy.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17021.
Date of creation: May 2011
Date of revision:
Note: AP EFG ME
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Other versions of this item:
- E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-05-14 (All new papers)
- NEP-BAN-2011-05-14 (Banking)
- NEP-BEC-2011-05-14 (Business Economics)
- NEP-MAC-2011-05-14 (Macroeconomics)
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